In 2022, the combination of higher inflation, higher interest rates, and falling growth stocks meant it looked like the post-Global Financial Crisis cycle had turned.
As the ‘Everything Bubble’ deflated and momentum shifted from in-demand crypto, tech and meme stocks to more fairly valued areas, many investors worried about recessions and more pain to come.
But the breakout success of artificial intelligence (AI), namely with the rise of ChatGPT, saved the day and allowed the ‘Everything Bubble’ to defy gravity by causing a huge reversal in sentiment – particularly for the ‘Magnificent Seven’ of Apple, Microsoft, Alphabet, Amazon, Meta, Tesla and Nvidia.
In 2023, these seven companies alone accounted for almost 70% of the S&P 500’s gains. And the better they did, the bigger they got, and the more they contributed to index returns. So, investors who stuck with index trackers and passive funds enjoyed a fantastic year.
So much so that the 2022 rebound in value, which at first looked like the start of a new cycle, now looks like a blip in a 17-year-long trend of growth-crushing value. However it’s important to keep in perspective that that trend is itself a bump in the road of value’s 200-year track record of outperformance.
In the current environment, however, growth’s rebound means that valuation spreads – the gap between the ‘haves’ and the ‘have-nots’, as the market sees them – have widened to extremes once again.
But today’s landscape is more complicated than it might seem.
Investment in the ‘Magnificent Seven’
The ‘Magnificent Seven’ (with the exception of perhaps one or two) are proven businesses with high margins, high returns on capital, and high growth. So it becomes easy to dream of seemingly endless AI-driven demand for Nvidia’s chips, and the products and services the other six will build using them.
This is in sharp contrast to the TMT era and ‘Everything Bubble’ where investors were drawn to unproven business models with catchy names.
However, in the current environment, one thing remains certain: expectations matter.
The market’s expectations can get ahead of even the best businesses, so that even if things turn out well, they may not turn out well enough – putting shares at risk. And with the index so unusually concentrated in the ‘Magnificent Seven’, a passive approach puts investors at risk that the weight of high expectations becomes too much to bear.
By contrast, contrarians seek out areas where the market’s expectations fall short of what we think a business is worth. And when expectations are low, things don’t need to turn out great for shares to do well. Just a little better than anticipated is often enough.
Contrarian investment
For example, let’s compare Microsoft and Corpay*. Microsoft needs no introduction, but chances are you’ve never heard of Corpay, the US payments company that’s currently in a top 10 position in the Orbis Global Equity Strategy.
Looking at the basic facts, Corpay has stronger historical earnings per share growth and a comparable return on invested capital. So, on growth and quality dimensions, the lesser-known Corpay compares pretty well to Microsoft.
Valuation is where things differ, however. Investors have high expectations of Microsoft, resulting in a rich valuation. Corpay, however, embeds low expectations, and is available at less than half the price-to-earnings ratio.
Another difference is in size. Microsoft earned almost $100bn in operating profit in 2023, and the market expects that to grow at around 10-15% per year – so it needs to grow profits by about $10bn-15bn per year, compounded over time. That’s like growing a brand-new Coca-Cola in 2024, and then adding another one in 2025, and so on. That becomes hard to sustain, even for the best companies in the world.
On the flip side, Corpay has an operating profit of just below $2bn, and it operates in a payments industry worth trillions. So it’s got lots of room to grow organically and through acquisitions.
Corpay (formerly Fleetcor) represents the kind of opportunity that’s not the biggest or most eye-catching prize, but one offering real value to investors willing to dig deeper: a good company available at a reasonable price that embeds low expectations.
Skilled active managers meticulously choose their targets, while passive funds grab indiscriminately due to their market-cap-weighted approach. This means traditional index funds are naturally overexposed to the most overvalued parts of the market and could struggle in environments like 2022 where the most overvalued or momentum-driven shares sell off the hardest and overlooked shares recover.
It’s clear the last two years have not really followed the traditional bust of a deflating bubble. The reality has been more awkward and muddled than that. But whether we’re entering a new cycle or still stuck in the old one – what we do know is that it’s an important time for investors to be adaptive and open-minded to avoid the allure of the seemingly obvious winners that come with potentially unrealistic expectations.
Instead, those unassuming opportunities that enhance your portfolio might just be the key to a winning strategy.
Nicola Dormehl is an investment councillor at Orbis Investments
